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Understanding Audit Techniques Can Help When Preparing Unfiled Tax Returns

If you have years of unfiled tax returns or are about to file for the current tax year, then understanding IRS audit techniques may help in preparing your tax return.

An IRS Agent employs either the direct, aka specific item, or indirect method or both to determine unreported income, overstatement of expenses, or fraudulent claims for credits or exemptions.

The IRS prefers the direct method whereby the auditor will review specific evidence such as public records, real estate deeds, or W-2s and 1099s to demonstrate additional income. If direct, specific, information is not available, then the IRS agent will use the indirect method.

The indirect method uses economic reality in which the taxpayer’s records are reconstructed through circumstantial evidence.  Common indirect methods are the bank deposit, net worth, and cash expenditures method of proving income.

Bank Deposit Method

When the auditor asks for bank statements, they are beginning to implement the bank deposit method.  The auditor will scrutinize all cash inflows and outflows in bank accounts to determine the appropriate income and expenses that should have been reported.  To guard against an IRS mistake, it is essential to determine whether or not money deposited is considered “income” and to make sure account transfers are counted once.

Cash Expenditures

This method compares all known sources of income with all known expenditures made during a year.  If the cash expenditures exceed your income, the IRS takes the difference as unreported income.  A good defense would be to show the IRS agent that someone else paid the expenditures or that you were using funds on hand or took out a loan etc.

Net Worth Method

The IRS likes utilizing the net worth method in criminal tax investigations.  The IRS will calculate the taxpayer’s net worth, total assets minus liabilities, at the beginning and ending of a period minus deductions and exemptions to derive at the correct taxable income.  The difference between the correct taxable income and what was reported equals unreported taxable income. The net worth method is flawed because not all increases in net worth are the result of taxable income.  For example, if you own real estate that appreciated from one year to the next.

How do Audit Techniques Help with Unfiled Tax Return Preparation?

When you prepare a draft of your tax return, you must review it in its entirety and to make sure all income and expenses were reported properly.  (See our blog post on September 17, 2012 regarding the audit selection).

Additionally, you must raise questions like an IRS agent utilizing the above techniques.  For example, if the draft of your return shows a large business loss with no supplemental income and you also have large itemized expenses, then think about how an IRS agent would utilize the direct and indirect audit methods in reviewing that return.

The IRS agent may inquire about how you paid for your living expenses, utilizing the cash expenditures method, or may inquire about assets at the beginning of the year and at years’ end, utilizing the net worth method.  If you’ve been using business expenses to pay for personal expenses, then you probably understated your income or overstated your expenses.

Think about it from the government’s perspective: How is it possible that you made no income, but were able to support your living expenses or buy new assets?

There may be plausible explanations.  Maybe, during the course of the year you took out a loan, received an inheritance, or your spouse contributed to family expenses, etc.  Another explanation may be that the losses were generated by “tax fiction” such as deductions that are not out of pocket expenses.  For example, depreciation is not literally an out of pocket, but nonetheless, taxpayers’ can use depreciation as an expense to reduce taxable income.  Taxpayers should never be afraid to take all legitimate expenses; however, you should review a return like an IRS agent and utilize direct and indirect audit methods.

When preparing unfiled tax returns, whether it’s last years’ return or years’ prior, a taxpayer should review all information reported by third parties, i.e. W-2s, 1099s etc, to ward off the IRS’s direct methods’ approach, and make sure what was reported is accurate.  Additionally, bank statements and credit card statements, assets purchased during the year, and yearly expenses should be reviewed.  Before filing a tax return, don’t just sign and date the tax return, but rather review it using IRS Agent techniques and see if it makes sense.

The Law Office of Todd S. Unger, Esq., LLC. focuses exclusively on IRS representation.  If you are experiencing difficulty with the IRS, then we can help.  We can help with years of unfiled tax returns, garnishments, levies, seizures, payroll tax disputes, and audits.

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